Consumer price index (cpi) explained: what it is and how it’s used

Critiques of CPI Methodology

Because the CPI Index is so crucial to economic policy and decision-making, its methodology has long been controversial, drawing claims it either understates or overstates inflation. A panel of economists commissioned by Congress to study the issue in 1995 concluded the CPI overstated inflation and was followed by calculation changes to better reflect substitution effects.

More recently, critics have claimed that adjustments for changes in product quality and features understate the CPI. According to the BLS, the particularly controversial hedonic adjustments, which use regression techniques to adjust prices for new features on a relatively small proportion of the CPI items, have a net effect close to zero on the index.

As the traditional CPI-U calculation only measures inflation for urban populations, it remains a less-than-reliable source of data for individuals living in rural areas. In addition, the CPI does not explicitly state how different demographics may be impacted by inflation. For example, soaring education costs may adversely impact younger individuals, while the impact of increasing elderly care costs is felt by a different group of individuals.

This notion is also widely attributable to individuals with varying degrees of income. For example, lower-income individuals who contribute more gross income towards necessities of shelter and food will skew differently than households with larger disposable income. For this reason, the CPI may not adequately reflect each individual’s experience in regard to costs and changes over time.

What Is the Current CPI?

The annual change in the CPI was 7.1% for the 12-month period ending November 2022. This was the smallest increase over a 12-month period since the same time frame ending December 2021.

How Is the Consumer Price Index Used?

The CPI Index is an inflation indicator closely watched by policymakers and financial markets. A related CPI measure is used to calculate cost-of-living adjustments for federal benefit payments.

How Is the CPI Calculated?

The Bureau of Labor Statistics samples 94,000 prices monthly to calculate the CPI, weighing the index for each product or service in proportion to its share of recent consumer spending to calculate the overall change in prices. The calculation also factors in the substitution effect as consumers shift spending away from the products rising in price on a relative basis. The CPI also adjusts for changes in product quality and features. The numbers are provided with and without seasonal adjustments.

What Are Some Criticisms of the CPI?

Over the years, the CPI has frequently drawn criticism that it has either understated or overstated inflation. Because the CPI is based on consumer spending, it doesn’t track third-party reimbursements for health care, and significantly underweights health care relative to its proportion in the GDP as a result. On the other hand, criticism concerning the quality adjustments used in the CPI has been widely discounted by economists.

What Is CPI?

CPI tracks the rate of change in U.S. inflation over time. This key economic metric is based on prices that consumers pay for goods and services throughout the U.S. economy. The percentage change in CPI over a period of time is referred to as the inflation rate.

The U.S. Bureau of Labor Statistics (BLS) releases a monthly CPI report that includes statistics about how the prices of different goods and services change over the last month and the last 12-month period.

The most recent CPI inflation report, for November 2022, showed that prices rose 7.1% over the prior 12 months. That means the cost of a basket of goods and services in the U.S. increased by an average slightly more than 7% from November 2021 to November 2022.

In addition to the headline data, there is also something called “core CPI” inflation. This measure offers a more stable reading on inflation because it strips out volatile food and energy prices from the calculation.

The core CPI inflation rate for November 2022 was 6%. This reading was down from the most recent peak—6.6% for the 12 months ending in September 2022, which marked 40-year high in core CPI.

How Is the CPI Used?

The CPI is widely used by financial market participants to gauge inflation and by the Federal Reserve to calibrate its monetary policy. Businesses and consumers also use the CPI to make informed economic decisions. Since CPI measures the change in consumers’ purchasing power, it is often a key factor in pay negotiations. 

The Federal Reserve

The Fed uses CPI data to determine economic policy. With a target inflation rate of 2%, the Fed may enact monetary policy to stimulate the economy should market growth slow or enact contractionary monetary policy should the economy (and therefore prices) become to grow too quickly. In response to higher-than-desired inflation rates via the CPI, the Fed adjusts the Fed funds rate.

Other Government Agencies

The cost-of-living adjustments (COLAs) based on the CPI affect federal payments to the approximately 70 million Americans receiving Social Security and Supplemental Security Income (SSI) benefits. They also apply to federal pension payments, school lunch subsidies, and income tax brackets.

Housing

Mortgage rates (and other forms of long-term debt) are often impacted by rates set by government agencies. As the CPI increases and the government enacts policy changes to slow inflation, rates often increase. On the other hand, landlords may use CPI information to adequately assess what annual rent increases for renters should be.

Financial Markets

Financial market prices are driven by countless factors. One such factor is the CPI, as reactionary Fed policies directly impact economic growth, corporate profits, and consumer spending ability.

A higher CPI often means that a less stringent government policy is generally in place. This means that debt is often easier to obtain for cheaper and that individuals have greater spending capacity. On the other hand, lower or decreasing CPI may indicate that the government may ease policy that helps boost the economy.

Labor Markets

The CPI and its components are also used as a deflator for other economic indicators, including retail sales and hourly/weekly earnings, to separate fundamental change from that reflecting change in prices. Employees may turn to CPI reports when approaching their employers for a raise based on nationwide increases to labor rates as well as pricing.

Be mindful that the CPI is published using national data; employees may be more suited to using local data to better understand their specific situation. In addition, some workers covered by collective bargaining agreements may have their wages tied to changes in CPI.

The BLS reports the CPI on a fixed, monthly cadence. A schedule of prior and future releases can be found on the BLS website, and the CPI is always released at 8:30am Eastern Time.

What Is the Consumer Price Index (CPI)?

The Consumer Price Index (CPI) measures the monthly change in prices paid by U.S. consumers. The Bureau of Labor Statistics (BLS) calculates the CPI as a weighted average of prices for a basket of goods and services representative of aggregate U.S. consumer spending.

The CPI is one of the most popular measures of inflation and deflation. The CPI report uses a different survey methodology, price samples, and index weights than the producer price index (PPI), which measures changes in the prices received by U.S. producers of goods and services.

Key Takeaways

• The Consumer Price Index measures the overall change in consumer prices based on a representative basket of goods and services over time.
• The CPI is the most widely used measure of inflation, closely followed by policymakers, financial markets, businesses, and consumers.
• The widely quoted CPI is based on an index covering 93% of the U.S. population, while a related index covering wage earners and clerical workers is used for cost-of-living adjustments to federal benefits.
• The CPI is based on about 94,000 price quotes collected monthly from some 23,000 retail and service establishments as well as 43,000 rental housing units.
• Housing rents are used to estimate the change in shelter costs including owner-occupied housing that account for nearly a third of the CPI.

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How Is CPI Calculated?

CPI is calculated by tracking the change in the prices of a fixed basket of goods and services.

The BLS refers to a variety of sources to calculate CPI, including the prices of goods and services from about 23,000 retail and service establishments throughout the U.S. It also collects data from about 50,000 landlords and tenants to determine the changes in the price of rent.

The basket of goods and services used for CPI includes popular items that Americans regularly purchase. The value of the items is proportional to how they are sold. The current cost of the basket is compared to its cost in the prior year, and then multiplied by 100 to determine the percentage.

Annual CPI = (value of basket in current year / value of basket in prior year) x 100

The calculated CPI is then used to determine the inflation rate.

Inflation Rate = (CPInew – CPIold) / CPIold x 100

How CPI Affects You

CPI figures might seem pretty abstract, but they reflect the very real price changes that affect every aspect of your day-to-day spending. CPI impacts your finances by:

• Measuring your purchasing power. CPI illustrates how much each dollar you earn can buy. As inflation drives up prices, the purchasing power of your money declines—that means you’re able to purchase fewer goods and services than you did previously with the same amount of money.
• Guiding economic policy. CPI is an economic indicator, a tool used to determine the impact of government economic policy. The Federal Reserve prefers a different measure of inflation—the personal consumption expenditures price index (PCE)—but it also pays attention to CPI. The Fed has begun raising interest rates due to high inflation.
• Determining government benefits. The federal government uses the CPI inflation rate to adjust payments for programs like Social Security (COLA), food stamps and public school lunches. It also uses the CPI to adjust income eligibility levels to participate in social programs.
• Driving salary increases at work. Private companies look at CPI inflation when deciding how much to increase employees wages every year. CPI data is a reliable metric for keeping prices and wages in line with competitors.

CPI Categories

The monthly CPI release from the BLS leads with the change from the prior month for the overall CPI-U as well as its key subcategories, along with the unadjusted change year-over-year. The BLS detailed tables show price changes for a variety of goods and services organized by eight umbrella spending categories.

Subcategories estimate price changes for everything from tomatoes and salad dressing to auto repairs and sporting events tickets. Price change for each subcategory is provided with and without seasonal adjustment. In addition to the national CPI indexes, BLS publishes CPI data for U.S. regions, sub-regions, and major metropolitan areas. The metro data is subject to wider fluctuations and is useful mainly for identifying the price changes based on local conditions.

The table below represents the CPI basket weighted distribution amongst the eight major expense categories. Be mindful that some subcategories may be difficult to spot within their major categories. For example, automobiles are classified under commodities.

Types of CPIs

The BLS publishes two indexes each month. The Consumer Price Index for All Urban Consumers (CPI-U) represents 93% of the U.S. population not living in remote rural areas. It doesn’t cover spending by people living in farm households, institutions, or on military bases. CPI-U is the basis of the widely reported CPI numbers that matter to financial markets.The BLS also publishes the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-W covers 29% of the U.S. population living in households with income derived predominantly from clerical employment or jobs with an hourly wage. CPI-W is used to adjust Social Security payments as well as other federal benefits and pensions for changes in the cost of living. It also shifts federal income tax brackets to ensure taxpayers aren’t subjected to a higher marginal rate as a result of inflation.

Understanding the Consumer Price Index (CPI)

The BLS collects about 94,000 prices monthly from some 23,000 retail and service establishments. Although the two CPI indexes calculated from the data both contain the word urban, the more broad-based and widely cited of the two covers 93% of the U.S. population.

Shelter category prices accounting for nearly a third of the overall CPI are based on a survey of rental prices for 43,000 housing units, which is then used to calculate the rise in rental prices as well as owners’ equivalents. The owners’ equivalent category models the rent equivalent for owner-occupied housing to properly reflect housing costs’ share of consumer spending. User fees and sales or excise taxes are included, while income taxes and the prices of investments such as stocks, bonds, or life insurance policies are not part of the CPI.

The calculation of the CPI indexes from the data factors in substitution effects—consumers’ tendency to shift spending away from products and categories has grown relatively more expensive. It also adjusts price data for changes in product quality and features. The weighting of the product and service categories in the CPI indexes corresponds to recent consumer spending patterns derived from a separate survey.

The CPI-U increased 7.1% over the 12-month period ending November 2022. While inflation remains historically high, November’s CPI was a welcome change from the 7.7% increase recorded in October 2022.

Breaking Down the Monthly CPI Report

The monthly CPI report includes inflation rates for various goods and services, as well as the rate of inflation in various regions across the United States.

The monthly CPI report starts with a summary of the findings, including how much inflation either increased or decreased for the month prior, followed by the average change in prices over the past 12 months.

The report includes information about which categories drove the increase or decrease in prices; in June 2022, for example, an increase in energy prices contributed to nearly half of the overall increase in the inflation rate.

Trends will also be noted in the CPI report about how the most recent findings compare over time, for both individual indexes and the overall inflation rate.

Information about food and energy price increases are both summarized in the beginning of the report, since these two categories directly impact consumers. Core inflation, which refers to inflation minus food and energy prices, comes next.

The CPI report includes a number of tables that break down how various goods and services increased over the past month, as well as the past 12 months. Everyday items, such as meat, vegetables, cleaning supplies and even clothing are tracked. The report also prices for used and new cars, rent and medical care.

It’s important to note that there is also seasonally adjusted data included in the CPI. Though this data isn’t what’s focused on in news reports, it exposes underlying trends in short-term price changes. Seasonally adjusted data strips out annual factors that affect prices, such as the busy summer travel season, which pushes up airfare costs.

Limitations of the CPI

Though the CPI is widely used as a tool to evaluate the overall health of the economy, it has limitations in what it reports and who it represents.

For example, the CPI only measures inflation for U.S. urban populations, thus leaving out the inflation experience of people living in rural areas. It also doesn’t include estimates of how different subgroups are experiencing inflation, such as the elderly or those living in poverty. By creating blanket assumptions of how people across varying demographics are experiencing inflation, monetary policy can’t fully capture or reach the needs of these different subgroups.

The CPI also includes substitution bias, which means it can overstate how much the cost of living has changed. For example, if the CPI captures a large increase in the price of an item, it doesn’t take into account people substituting that item for a cheaper one. Not taking this into account wrongly assumes that people continue to buy the more expensive item and experience a higher inflation rate than what they’re actually enduring.

CPI vs. Unemployment

In the broadest sense, the CPI and unemployment rates are often inversely related. This is not always the case in every economy, but the Federal Reserve often attempts to decrease one metric while balancing the other. For example, in response to the COVID-19 pandemic, the Federal Reserve took unprecedented supervisory and regulatory actions to stimulate the economy.

As a result, the labor market quickly strengthened and bottomed at 3.5% in July 2022. However, this stimulus has resulted in the highest CPI calculations in decades.

As a result of higher-than-targeted CPI calculations, the Federal Reserve began raising interest rates and tapering certain asset purchases. On one hand, these measures aim to slow economic growth, make it more expensive for consumers to acquire debt, and stem monetary supply growth.

On the other hand, these additional expenses may burden households and make companies less profitable. All else being equal when the Federal Reserve attempts to lower the CPI, it runs the risk of unintentionally increasing unemployment rates.

CPI Formulas

The more common CPI-U calculation entails two primary formulas. The first is used to determine the current cost of the weighted-average basket of products, while the second is used to analyze the year-over-year change.

Annual CPI Formula

To calculate the annual CPI, the BLS divides the value of a specific basket of goods today compared to one year ago:

As mentioned earlier, the basket of goods and services used in the CPI calculation is a composite of popular items commonly purchased by Americans. The weight of each component of the basket is in proportion to how they are sold. The annual CPI is reported as a whole number, and the figure is often greater than 100 (assuming current market prices are appreciating).

Then, the BLS uses the current year’s CPI and the prior year’s CPI to calculate the inflation rate.

The inflation rate can be calculated for a given month or annual period; in either case, the appropriate new and prior period must be selected. The inflation rate is reported as a percentage and is often positive (assuming current market prices are appreciating).